3. Real Interest Rate, (percent) Quantity of Loanable Funds Loanable Funds Market [*Use this graph if there is a chg in savings by consumers or chg in fiscal policy] [* Use the Money Market graph when there is a change in MS ] r=6%r=6%r=6%r=6% D1D1D1D1 F1F1F1F1 S balanced budget Starting from a balanced budget, if the G incr spendingdecr T G incr spending or decr T to get out of recession a recession, they would now be running deficitpushing a deficit and have to borrow, pushing up demand in the LFMincreasing up demand in the LFM and increasing the interest rate the interest rate. D2D2D2D2 r=8%r=8%r=8%r=8% F2F2F2F2 E1E1E1E1 E2E2E2E2 “real interest rate” Use the “real interest rate” with LFMlong-term LFM, because it is long-term. “nominal interest rate” Use “nominal interest rate” with money marketshort-term money market, as it is short-term. Borrowers Lenders $ 2 tril. G T Balanced Budget [G & T=$2 Tr.] $2.2 tril. $2 tril. $2 tril.

4. Real GDP PL SRAS AD 2 YRYRYRYR YFYF [Incr G; Decr T] [Incr G; Decr T] P L1 AD 1 PL 2 G ADY/Empl./PL; G LFM I.R. T DIDI CAD ; Y/E mp. /PL; T LFM IRIR Start from a Balanced Budget G & T = $2 Trillion $2 tril. “I can’t get a job.” “N ow, this is better.” G T E1E1E1E1 E2E2 LRAS D1D1 D2D2 S Loanable Funds Market r =6 % r =8 % Real In. Rate F1F1 F2F2 $2 tril. $2.2 tril. $2.2 $2.2 $1.8 $1.8

5. Real GDP PL SRAS AD 2 YIYIYIYI YFYF Decr GIncr T [Decr G; Incr T ] P L1 AD 1 PL 2 G ADY/Empl./PL; G LFM I. R. T DIDIDIDICAD Y/Emp/PL; TLFM IRIRIRIR Start from a Balanced Budget G & T = $2 Trillion $2 tril. G T [like we have “money trees” “money trees”] E1E1E1E1 E2E2 LRAS Loanable Funds Market Real In. Rate r =3 % r =6 % D1D1 D2D2D2D2 F1F1 F2F2F2F2 S $2 T tril. $2.2 T tril. $1.8 tril.. $ 1.8 $2.2 $2.2

6. E1E1E1E1 1.Government cuts defense spending 1.Government cuts defense spending by $75 billion. As a result the following occur: Unemployment9% - Unemployment increases from 6% to 9% GDP3% - GDP drops 3% Inflation1% - Inflation drops from 3% to 1% AD1AD2 Based on this info, draw AD1 to AD2 on the graph. ……………………………………………………………… “G” decreases taxesDI A. Now “G” decreases taxes, which (incr/decr) DI, CAD which (incr/decr) C, which (incr/decr) AD. [starting balanced budgetGDP a balanced budget] The result is an (incr/decr) in GDP, employment & PL. With the increase of government’s demand for loanable funds, because they now have interest rate less tax revenue, the interest rate (increase/decrease). AD1 AD2 Draw the new AD1 to AD2 curves on the graph. interest ratesdollar B. Due to the change in interest rates, the dollar exports (appreciates/depreciates) and our exports (incr/decr). AP Macro FRQ Practice 1 LRAS SRAS LRASSRAS E2E2E2E2 E1E1E1E1 E2E2E2E2 Y*Y*Y*Y* Real Y PL 2 PL PL Y* Y* Y* Y* AD 1 AD 2 YRYR9%9%YRYR9%9% YRYR9%9%YRYR9%9% AD 1 AD 2 PL 1

7. Net exports increase by $50 billion 2. Net exports increase by $50 billion due to a depreciated dollar, resulting in the following: Unemployment3% - Unemployment stays at 3% GDPsame - GDP stays the same Inflation8% to 10% - Inflation increases from 8% to 10% AD1 to AD2 Based on this info, draw AD1 to AD2 on the graph. ……………………………………………………………… government decreases spendingby $100 bil A. Now government decreases spending by $100 bil. AD which leads to an (increase/decrease) in AD. GDPemployment The result is an (incr/decr) in GDP, employment, PL and PL. With the reduction of “G”’s demand for dollars in the LFM, because of the decrease in “G”, the interest rate (increases/decreases). AD1AD2 Draw the new AD1 to AD2 curves on the graph. change in price leveldollar B. Due to the change in price level, the dollar imports (apprec/deprec) and our imports (increase/decrease). AP Macro FRQ Practice 2 AD 1 AD 2 AD1 AD2 LRAS SRAS LRAS E1E1E1E1 E2E2E2E2 E1E1E1E1 E2E2E2E2 PL PL 1 PL 2 Y I 3% Y*Y*Y*Y* Real GDP Y I 3% Y*Y*Y*Y* PL 2 PL 1 SRAS PL

8. Government spends $99 billionon a war 3. Government spends $99 billion on a war with Cuba. As a result the following occur: Unemployment14% to 10% - Unemployment decreases from 14% to 10% GDP10% - GDP increases 10% Inflation0% - Inflation is 0% AD1 to AD2 Based on this info, draw AD1 to AD2 on the graph. ……………………………………………………………… government decreases taxes by $150 billion A. Now government decreases taxes by $150 billion C which (incr/decr) DI, which (incr/decr) C, which ADGDP (incr/decr) AD. The result is an (incr/decr) in GDP, employmentPL employment, & PL. With the increase of government’s demand for LF, because they now have less tax interest rate revenue, the interest rate (increases/decreases). increase in the growth ratedollar B. Due to the increase in the growth rate, the dollar imports (apprec/deprec) and our imports (increase/decrease). AP Macro FRQ Practice 3 AD1 AD2 AD1 AD2 LRAS SRAS LRAS SRAS Real GDP Y R 10% Y*Y*Y*Y* PL PL 2 E1E1E1E1 E2E2E2E2 Y R 14% Y*Y*Y*Y* E1E1E1E1 PL 1 PL PL Y R 10% E2E2E2E2

9. Government spends $100 billion on the infrastructure. 4. Government spends $100 billion on the infrastructure. As a result the following occur: Unemployment3% - Unemployment decreases from 6% to 3% GDP5% - GDP increases 5% Inflation2% to 6% - Inflation increases from 2% to 6% AD1 to AD2 Based on this info, draw AD1 to AD2 on the graph. ……………………………………………………………… government increases taxes by $100 billion, A. Now government increases taxes by $100 billion, C which (incr/decr) DI, which (incr/decr) C, which ADGDP (incr/decr) AD. The result is an (incr/decr) in GDP employmentPL employment, and PL. With the decrease of “G”’s demand for dollars in the LFM, because of the increase in “T”, the interest rate (incr/decr). AD1AD2 Draw the new AD1 to AD2 curves on the graph. change in interest ratedollar B. Due to the change in interest rate, the dollar exports (apprec/deprec) and our exports (increase/decrease). AP Macro FRQ Practice 4 AD 1 AD 2 AD 1 AD 2 LRAS SRAS LRAS E1E1E1E1 E2E2E2E2 E1E1E1E1 E2E2E2E2 PL PL 1 PL 2 YIYI3%3%YIYI3%3% Y*Y*Y*Y* Real GDP Y I 3% Y*Y*Y*Y* PL 2 PL 1 SRAS The economy is guilty of breaking the “FE 4% Speed Limit.” We are going to have to raise interest rates. Wait a minute – this is monetary policy. We’ll attack this on the next test. Let’s look again at fiscal policy. PL

10. Net exports decrease by $60 billion 5. Net exports decrease by $60 billion due to an appreciated dollar, resulting in the following: Unemployment - Unemployment stays at 3% GDP - GDP stays the same Inflation - Inflation drops from 10% to 6% AD1 to AD2 Based on this info, draw AD1 to AD2 ……………………………………………………………. government decreases spending by $90 A. Now government decreases spending by $90 billion AD billion which leads to an (incr/decr) in AD. GDPemployment The result is an (incr/decr) in GDP, employment, PL & PL. W ith the reduction of “G”’s demand for LF, interest rate because of the decrease in “G”, the interest rate (increases/decreases). Draw the new AD1 to AD2 curves on the graph. change in PLdollar B. Due to the change in PL, the dollar imports (apprec/deprec) and our imports (incr/decr). AP Macro FRQ Practice 5 AD 2 AD 1 AD 2 SRAS SRAS PL 1 PL2PL2PL2PL2 Y I 3% Y*Y*Y*Y* Y*Y*Y*Y* 3% PL 1 PL 2 E1E1E1E1 E1E1E1E1 E2E2E2E2 E2E2E2E2 LRAS LRAS PL PL

11. Rising U.S. tariffs cause Xn to drop by $30 billion 6. Rising U.S. tariffs cause Xn to drop by $30 billion. As a result the following occur: Unemployment10% to 12% - Unemployment increases from 10% to 12% GDP8% - GDP decreases 8% Inflation0% - Inflation is 0% Based on this info, draw AD1 to AD2 on the graph. ………………………………………………………………. N ow government decreases taxes by $125 b illion A. N ow government decreases taxes by $125 b illion which DICAD (incr/decr) DI, which (incr/decr) C, which (incr/decr) AD. GDPPL The result is an (incr/decr) in GDP, employment, and PL. With the increase of government’s demand for LF, i nterest r ate because they now have less tax revenue, the i nterest r ate AD1 (incr/decr). Draw the new AD1 to AD2 on the graph. increase in the growth ratedollar B. Due to the increase in the growth rate, the dollar exports (apprec/deprec) and our exports (increase/decrease). AP Macro FRQ Practice 6 AD1 AD 2 AD1 LRAS SRAS LRAS SRAS Y*Y*Y*Y* Y R 12 % Y R 12 % Y R 10 % Y*Y*Y*Y* PL 1 PL PL 2 E2E2E2E2 PL PL E1E1E1E1

12. Fiscal Policy FRQ Practice Question 1 1. Suppose the following conditions describe the current state of the economy. -The unemployment rate is 3.5% -Real GDP is growing at the rate of 5% inflation rate is 9% -The inflation rate is 9% (a) Identify the main problem this economy faces [inflation] increase personal income taxes (b) Now Congress votes to increase personal income taxes. Using AD/AS analysis [graph this], explain what effect this policy will have on each of the following. (i) AD, & thus output & employment (ii) The price level (iii) The interest rateAnswers: (i) The increase in personal taxes will decrease DI, which will decrease C, which will decrease AD, decrease output and employment which will decrease output and employment. (ii) The decrease in AD will result in a lower lower price level equilibrium [AD1 to AD2 & E1 to E2] and a lower price level. (iii) The increase in personal taxes results in more tax revenue v. government spending, which decreases the demand for money decrease in interest rates in the LFM & a decrease in interest rates.

13. Fiscal Policy FRQ Practice Question 2 Fiscal Policy FRQ Practice Question 2 nominal wage rates rise faster than labor 2. Assume that in the U.S., nominal wage rates rise faster than labor productivityAD/AS analysis [graph this] productivity. Using AD/AS analysis [graph this], analyze the short- run effects of this situation on each of the following. [Base your (b) answer on what the price level does] (a) The general price level (b) The international value of the dollar [based on PL] (c) The level of exportsAnswers: (a) As shown ( graph), nominal wage rates rising faster than labor productivity would decrease the AS curve from AS 1 to AS 2. The decrease in AS would change equilibrium from E 1 to E 2, which would result in a higher general price level. (b) The higher price level would make our exports more expensive relative to foreign goods, thus decreasing demand for the U.S. depreciating the dollar. dollar and depreciating the dollar. (c) The depreciated dollar would make our goods cheaper than the increase our exports previous period and increase our exports.

14. Y R DMDMDMDM Investment Demand nominal Interest Rate 8 4 0 Money Market QID1 MS 1 AS AD 1 PL 1 8% 8% 6% 4% 0 MS 2 AD 2 PL 2 Price level If there is a RECESSION MS will be increased. QID2 DIDIDIDI Y* Buy B onds MS I.R.QID AD Y / E mp/ PL I want a job as a Rockette Real GDP Buy E1E1E1E1 E2 6%

15. DIDIDIDI AD 1 Price level Y I DmDm Investment Demand Nominal Interest Rate 10 % 8% 6% 0 Money Market QID 2 AS 10 8 6 0 AD 2 PL 2 MS 1 PL 1 MS 2 If there is INFLATION, MS will be decreased. Sell QID 1 Y*Y*Y*Y* “It’s cheaper to burn money than wood.” SellBonds MSI.R. QID AD Y/E mpl. /PL like “money trees” E1E1E1E1 E2E2E2E2

16. SRAS LRAS AD 1 PL 1 Y* Japanese (b) [3 pts] Japan is a major importer of U.S. products. Assume that the Japanese economy goes into arecession economy goes into a recession. impact of the Japanese recession on the U.S. (i) Explain the impact of the Japanese recession on the U.S. equilibrium output and price levels equilibrium output and price levels. Show these effectson your graph (ii) Show these effects on your graph in part (a). Answer (b)(i) & (ii): Answer (b)(i) & (ii): The Japanese recession would cause job losses in Japan, lowering prices and incomes there, which would reduce U.S. exports to Japan. This would decrease aggregate demand in the U.S, decrease PLoutputand employment which would decrease PL, output, and employment. AD 2 PL 2 YRYRYRYR E1E1E1E1 Real GDP Free Response 2005 U.S. economy is currently in equilibrium at the 1. [13 total pts] Assume that the U.S. economy is currently in equilibrium at the full-employment level of real GDP full-employment level of real GDP. correctly labeled graph of AD/AS (a) [3 pts] Draw a correctly labeled graph of AD/AS showing each of the following in the U.S. Output level (i) Output level Price level (ii) Price level E2E2E2E2

17. Fed takes action to curb the effects (c) [5 pts] Assume that the Fed takes action to curb the effects of the Japanese recession of the Japanese recession on the U.S. economy. open-market operation (i) What open-market operation would the Fed undertake? Answer (c) (i):buy bonds Answer (c) (i): The Fed would buy bonds which would increase the MS and decrease interest rates. correctly labeled graph of the money market (ii) Use a correctly labeled graph of the money market to show how the affect the nominal interest rate Fed policy action will affect the nominal interest rate. Answer (c) (ii):buying bondsbigger MS Answer (c) (ii): The Fed buying bonds would mean a bigger MS, which lower nominal interest rates would lead to lower nominal interest rates. change in the nominal interest rate (iii) Explain how the change in the nominal interest rate in part (c) (ii) affect ADprice levelreal output will affect AD, price level, and real output in the U.S. Answer (c) (iii): Answer (c) (iii): As seen in the graphs above, the decrease in the nominal interest rate would increase investment, which would increase AD. The increase in ADincrease price levelreal output increase in AD would increase price level and real output in the U.S. FR 2005

18. real interest rate (d) [1 pt] Define the real interest rate. FR 2005 Answer 1 (d):nominal interest rate less the Answer 1 (d): The real interest rate is the nominal interest rate less the expected rate of inflation expected rate of inflation. open-market operation (e) [1 pt] Indicate the effect of the open-market operation you identified on the real interest rate in the U.S. in part (c) on the real interest rate in the U.S. Answer (e): Answer (e): The buying of bonds by the Fed would increase the MS, which increase AD would decrease the interest rate, which would increase Ig and increase AD and price level and price level. The increase in PL would be subtracted from the nominal decrease the real interest rate interest rate, which would decrease the real interest rate.

19. Real Interest Rate Quantity of Funds r =8% D1 F1F1F1F1 S D2 r =10% F2F2F2F2 E1E1E1E1 E2E2E2E2 Demand for Funds upply of Funds FR 2005 Loanable Funds Market loanable funds market 2. [8 total pts] The graph above shows the loanable funds market for a country. government increases deficit spending (a) [2 pts] Assume that now the country’s government increases deficit spending. increase in deficit spending will affect the real interest rate Explain how the increase in deficit spending will affect the real interest rate. Answer 2. (a): Answer 2. (a): The increase in deficit spending means the government has to borrow more increase in demand in the LFM increases the real interest rate in the LFM. The increase in demand in the LFM increases the real interest rate. real interest rate change (b) [1 pt] Indicate how the real interest rate change you identified in part (a) will affect the investmentin plant and equipment will affect the investment in plant and equipment. Answer 2. (b): Answer 2. (b): The increase in the real interest rate will make plant & equipment decrease investment in those projects projects less profitable and will decrease investment in those projects. That “crowding-out” is, there is “crowding-out” of investment, due to the higher interest rate.

20. FR 2005 how the real interest rate change (c) [2 pts] Explain how the real interest rate change you identified in part (a) will affect long-term economic growth will affect long-term economic growth. Answer 2. (c): Answer 2. (c): Because the real interest rate increased in part (a), there will be lower investment in plant & equipment lower investment in plant & equipment that make up that country’s national making its citizens less productive factory, therefore making its citizens less productive. This will result in slower long-term economic growthLRAS curve left slower long-term economic growth and shift the LRAS curve left. However, unless there is negative net investment, there could still be economic growth. real interest rate change (d) [3 pts] Explain how the real interest rate change you identified in part (a) will affect each of the following will affect each of the following in the foreign exchange market. demand for the country’s currency (i) The demand for the country’s currency value of the country’s currency (ii) The value of the country’s currency Answer 2. (d), (i) & (ii): Answer 2. (d), (i) & (ii): With real interest rates increasing in part (a), the demand for financial capital (CDs, bonds, etc.) in that country will increase because of the greater relative return on them. (i)more demand for its currency. (i) This will result in more demand for its currency. (ii) (ii) The increase in demand, caused by better return on its financial capital, will increase the value of that nation’s currency, appreciating it.

21. unemployment 3. [4 total pts] Assume that the table below shows the unemployment inflation Country X and inflation data in Country X as a result of a shift in AD. FR 2005 PeriodUnemployment Rate Inflation Rate PeriodUnemployment Rate Inflation Rate 2%8% Last Year 2%8% 5%4% This Year5%4% correctly labeled graph of a short-run Phillips curve (a)[2 pts] Draw a correctly labeled graph of a short-run Phillips curve for Country Xshowing the actual unemploymentinflation rates Country X, showing the actual unemployment and inflation rates for both years. SRPC Label the Phillips curve as SRPC. Inflation Unemployment 8% 2% 4% 5% SRPCSRPCSRPCSRPC SRAS (b) [2 pts] Now assume that the SRAS curve has shifted to the left curve has shifted to the left. (i) Identify one factor that could cause the AS curve to shift to the left cause the AS curve to shift to the left. Answer 3 (b) (i): increase in input Answer 3 (b) (i): An increase in input cost cost could shift the AS curve left. [Other OK answers would be increase in bus. regs., increase in business taxes, decrease in subsidies, or an increase in expected inflation.] show how this shift (ii) On the graph, show how this shift would affect the short-run Phillips curve. SRPC*SRPC*SRPC*SRPC*

22. FR 2005 Inflation Unemployment 8%8%8%8% 2% 4%4%4%4% 5% SRPCSRPCSRPCSRPC natural rate of unemployment in Country X is 5%Draw (c) [1 pt] Assume that the natural rate of unemployment in Country X is 5%. Draw a correctly labeled graph of the long-run Phillips curve and label it asLRPC a correctly labeled graph of the long-run Phillips curve and label it as LRPC. LRPC relationship between the unemployment rate and the (d) [1 pt] What is the relationship between the unemployment rate and the inflation rate in the long run inflation rate in the long run? Answer 2. (d):no relationshipbetween the unemployment rate Answer 2. (d): There is no relationship between the unemployment rate and inflation in the long run and inflation in the long run. As can be seen in the graph above. If there is inflationdisinflationincreasesdecreases unanticipated inflation or disinflation, although PL increases or decreases, unemployment ends up at the natural rate unemployment ends up at the natural rate.

23. 2004 Macro Free Response less than full employment 1.Assume our economy is operating at less than full employment. correctly labeled AD & AS graph (a) Using a correctly labeled AD & AS graph, show the following. Full-employment output (i) Full-employment output Current output (ii) Current output Current price level (iii) Current price level open-market operation (b) Identify an open-market operation that could restore full employment in the short run. Answer: An open-market operation to increase AD would buying bonds be the Fed buying bonds. NeedJob Y R Y F Real GDP My InfoTech job was outsourced to India.

24. graph of the money market (c) Using a correctly labeled graph of the money market, show how the I.R. in the SR open market operation you identified in part (b) affects the I.R. in the SR. MS 2 IR 2 QID2QID2QID2QID2 AD 2 PL 2 Quantity of Investment E2E2E2E2 This job is more like it. change in the interest rate affect AD (d) Explain how the change in the interest rate you identified in part (c ) will affect AD. Answer: Answer: The decrease in the interest rate will increase QID increase AD and consumption which will increase AD. (It will also increase Xn because it depreciates the dollar, making our products cheaper.) (e) Show on the graph in part (a) how the change in the I R you identified in affect output and price level part (c) will affect output and price level. Answer: increase AD which will Answer: The lower I R will increase Q I D, which will increase AD which will increase output and price level increase output and price level as shown by the movement from AD1 to AD2. YFYFYFYF Money Market YRYRYRYR Answer:decreases the I.R. in the SR Answer: See the above graph. The increase in MS decreases the I.R. in the SR.2004NominalInterestRates

25. no policy actions are (f) Instead of the open-market in part (b), suppose that no policy actions are takenflexible prices & wages taken to address the unemployment problem. With flexible prices & wages, explain how each of the following will eventually change. Short-run AS (i) Short-run AS Output and price level (ii) Output and price level-20% $10 $8 Y* Y* SRAS 1 SRAS 2 AD 1 AD LRAS PL YRYRYRYR RGDP Answer: Answer: As price level drops, workers will accept lower wages. With cheaper shifting the SRAS curve to the resource cost, firms will hire more workers shifting the SRAS curve to the right, decreasing price level and increasing output right, decreasing price level and increasing output. Surplus

26. national saving in the U.S. increases real interest rate in the U.S 2. (a) Assume that national saving in the U.S. increases. Explain the effect of this increase on the real interest rate in the U.S. Answer: Answer: If national savings increase, then banks have more loanable decrease in the real interest rate funds. More LF would lead to a decrease in the real interest rate. real interest rates in the rest of the world (b) Suppose that real interest rates in the rest of the world remain unchanged remain unchanged. (i) Explain the effect of the real interest rate change in the U.S. demand for the U.S. dollar that you identified in part (a) on the demand for the U.S. dollar in the foreign exchange market. Answer: Answer: Because the U.S. real interest rate is going down and they are decrease unchanged in the rest of the world, foreign investors would decrease their demand for U.S. financial assets their demand for U.S. financial assets because of less return on the lower real I.Rates. (ii) As a result of the effect you identified in (i), what will happen international value of the U.S. dollar to the international value of the U.S. dollar? Answer: Answer: The decrease in foreign demand for U.S. financial assets depreciate the dollar because of the decreasing interest rate would depreciate the dollar. (c) Given your answer in part (b), indicate how each of the following U.S. importsU.S. exports will change. (i) U.S. imports (ii) U.S. exports Answer: U.S. imports would decrease Answer: U.S. imports would decrease because the depreciated dollar U.S. exports would increase would make imports more expensive. U.S. exports would increase because the depreciated dollar would make U.S. exports cheaper. LFM or Money Market? LFM or Money Market? “Money Market”modelvertical MS Fed changes t he MS Use the “Money Market” model, with the vertical MS, when the Fed changes t he MS. “LFM” modelupward sloping supply curve Use the “LFM” model, with the upward sloping supply curve, if there is a “change in savings”“change in demand for loanable funds” “change in savings” or “change in demand for loanable funds”, such as expansionary or contractionary fiscal policy expansionary or contractionary fiscal policy.

27. Fed buys $5,000 in bonds from Clark Consulting Services change in MS if RR is 100 % 3. The Fed buys $5,000 in bonds from Clark Consulting Services, which then deposits the money in a checking account at First Generation Bank. (a) As a result of the Fed’s action, what is the change in MS if RR is 100 % ? Answer:$5,000DD Answer: The change in MS would be the $5,000 DD. RR is reduced to 10% (b) If the RR is reduced to 10%, calculate the following. this bank could lend (i) The maximum amount this bank could lend from this deposit. Answer:loan out $4,500 Answer: With 10% or $500 in RR, the bank could loan out $4,500. maximum increase in the total MS (ii) The maximum increase in the total MS from the Fed’s bond purchase. Answer: Answer: Potential money creation in the banking system could be as much as $45,000 [10x$4,500=$45,000]. Clark Consulting has a DD TMS of $50,000 of $5,000. Adding these two together gives a TMS of $50,000. banks keep some of the deposit as ER (c) If banks keep some of the deposit as ER, how will this influence change in the MS the change in the MS that was determined in part (b)(II)? Explain. Answer: Answer: If the bank doesn’t loan out all of the $4,500 ER, then the not be as much as $4,500 1 st loan would not be as much as $4,500, therefore reducing PMC. public decides to hold some money in the form of currency (d) If the public decides to hold some money in the form of currency change in rather than in demand deposits, how will this influence the change in the money supply the money supply that was determined in part (b)(ii)? Explain. Answer: Answer: If the public gets the loan and holds part of it as currency, then this is a leakage in the PMC of the banking system. If the person who takes the $4,500 loan from First Generation Bank takes $500 in cash, then only reducing the PMC $4,000 gets deposited in the next bank, thus reducing the PMC of the system.

29. recession 1.Assume the U.S. economy is operating at full-employment output and the government has a balanced budget. A drop in consumer confidence reduces consumption spending, causing the economy to enter into a recession. (a) Using a correctly labeled graph of the short-run Phillips curve, show the effect “A” of the decrease in consumption spending. Label the initial position “A” and the “B” new position “B”. recession (b) What is the impact of the recession on the federal budget? Explain. Inflation Unemployment 2%2%2%2% 7% 4%4%4%4% 5% SRPCSRPCSRPCSRPC A B Answer to 1. (b): The decrease in consumption would result in a decrease in AD and a decrease in GDP. The decrease in consumption would result in a decrease in AD and a decrease in GDP. This would result in an increase in unemployment and an increase in transfer payments. This would result in an increase in unemployment and an increase in transfer payments. Due to the job losses, there would be a decrease in tax revenues, resulting in an increase Due to the job losses, there would be a decrease in tax revenues, resulting in an increase in government red ink for the federal budget. So a federal budget deficit would increase in government red ink for the federal budget. So a federal budget deficit would increase or a federal budget surplus would decrease. or a federal budget surplus would decrease. A. W. Phillips 1914-1975 2 pts – 1 pt for correctly labeled SRPC graph. 1 pt for initial & new pt on SRPC graph. 1 pt for initial & new pt on SRPC graph. 2 pts - 1 pt for budget deficit and 1 pt for explanation.

30. (c) Assume current real GDP falls short of full-employment output by $500 billion and the MPC is 0.8. (i) Calculate the minimum increase in government spending that could bring about full employment. Answer to 1. (c) (i): The expenditure multiplier [ M E ] would be 5 [1/.2 = M E of 5]. Because current output The expenditure multiplier [ M E ] would be 5 [1/.2 = M E of 5]. Because current output falls short by $500 billion, it would take a minimum increase in government spending falls short by $500 billion, it would take a minimum increase in government spending of $100 billion to get to full employment. [5 X $100 = $500] of $100 billion to get to full employment. [5 X $100 = $500] (ii) Assume that instead of increasing government spending, the government decides to reduce personal income taxes. Will the reduction in personal income taxes required to achieve full employment be larger than or smaller than the government spending change you calculated in part (c) (i)? Explain why. Answer to 1. (c) (ii): Because the tax multiplier [ M T ] is smaller, or [MPC/MPS =.8/.2 = 4], it will take a larger Because the tax multiplier [ M T ] is smaller, or [MPC/MPS =.8/.2 = 4], it will take a larger tax cut then the increase in government spending. Because current output is $500 bil. tax cut then the increase in government spending. Because current output is $500 bil. short of FE Y, and the M T is 4, it would take a tax cut of $125 billion. [4 X $125 = $500] short of FE Y, and the M T is 4, it would take a tax cut of $125 billion. [4 X $125 = $500] 3 pts – 1 pt – $100; 1 pt – larger Tax reduction; 1 pt – larger Tax reduction; 1 pt – smaller M T or not all increased Y spent. 1 pt – smaller M T or not all increased Y spent.

31. Real Interest Rate, (percent) rir = 6 % D1D1D1D1 F1F1F1F1 S D2D2D2D2 rir = 8 % F2F2F2F2 E1E1E1E1 E2E2E2E2 Borrowers Lenders $ 2 T G T Balanced Budget [G&T=$2 Tr.] $2.1 Tril. after $100 B increase $2 T $2 T (d) Using a correctly labeled graph of the loanable funds market, show the impact of the increased government spending on the real interest rate in the economy. (e) How will the real interest rate change in part (d) affect the growth rate of the U.S. economy? Explain. Answer to 1. (d) Answer to 1. (d) As can be seen on the LF graph, the RIR would increase as the government has to borrow As can be seen on the LF graph, the RIR would increase as the government has to borrow more than previously, increasing demand in the LFM, which pushes up the RIR. more than previously, increasing demand in the LFM, which pushes up the RIR. Answer to 1. (e): The increase in RIR will decrease real Ig, decreasing capital stock. This will decrease AD and decrease GDP or growth rate in the U.S. economy. 2 pts – 1 pt – correctly labeled LFM graph; 1 pt – rightward shift of D curve 1 pt – rightward shift of D curve or leftward supply shift. or leftward supply shift. 2 pts – 1 pt – growth rate falls; 1 pt – Ig decreases, slowing capital formation. 1 pt – Ig decreases, slowing capital formation.

32. 2. Balance of payments accounts record all of a country’s international transactions during a year. (a)Two major subaccounts in the balance of payments accounts are the current account and the capital account. In which of these subaccounts will each of the following transactions be recorded? (i) A United States resident buys chocolate from Belgium. (b) How would an increase in the real income in the United States affect the United States current account balance? Explain. (ii) A United States manufacturer buys computer equipment from Japan. Answer to 2. (a) (i): Answer to 2. (a) (i): Chocolate from Belgium would go in the current account as it includes the import of goods. Chocolate from Belgium would go in the current account as it includes the import of goods. Answer to 2. (a) (ii): Answer to 2. (a) (ii): Computer equipment by a U.S. manufacturer would also be classified as an import so it Computer equipment by a U.S. manufacturer would also be classified as an import so it would also go on the current account. would also go on the current account. Answer to 2. (b): Answer to 2. (b): An increase in real income would make U.S. citizens richer. We would buy more imports, An increase in real income would make U.S. citizens richer. We would buy more imports, decreasing net exports, and increasing the deficit on the current account. decreasing net exports, and increasing the deficit on the current account. 1 pt – current account 2 pts - 1 pt – imports increase or Xn decrease. 1 pt – current account balance decreases or current account balance goes into deficit. 1 pt – current account balance decreases or current account balance goes into deficit.

33. 2 pts - 1 pt – correctly labeled foreign exchange graph for the dollar. 1 pt – rightward shift in supply and depreciation of the dollar. 1 pt – rightward shift in supply and depreciation of the dollar. R25 Quantity of Dollars Rupee Price of Dollar R50 R50 P rice $S1$$S1$ D1$D1$D1$D1$ A D R100 E1E1E1E1 E2E2E2E2 S2$S2$S2$S2$ Rupeeappreciates R looking for $’s $’s looking for R (c) Using a correctly labeled graph of the foreign exchange market for the U.S. dollar, show how an increase in U.S. firms’ direct investment in India will affect the value of the U.S. dollar relative to the Indian currency (the rupee). Answer to 2. (c): Answer to 2. (c): The increase in investment in India will increase demand for the rupee & appreciate that The increase in investment in India will increase demand for the rupee & appreciate that currency. This would result in an increase in supply of the U.S. dollar for more rupees, currency. This would result in an increase in supply of the U.S. dollar for more rupees, depreciating the dollar. depreciating the dollar.

34. 3. The PPCs for Artland & Rayland are shown. Using equal amounts of resources, Artland can produce 600 hats or 300 bicycles, & Rayland can produce1,200 hats or 300 bicycles. (a)Calculate the opportunity cost of a bicycle in Artland. (b) If the two countries specialize and trade, which country will import bicycles? Explain. (c) If the terms of trade are 5 hats for 1 bicycle, would trade be advantageous for each of the following? (i) Artland (ii) R ayland (d) If productivity in Artland triples, which country has the comparative advantage in the production of hats? Answer to 3. (a): Answer to 3. (a): The Domestic Comparative (opportunity cost) of a bicycle The Domestic Comparative (opportunity cost) of a bicycle in Artland is 2 units of hats. [1 bicycle = 2 hats or 600/300=2] in Artland is 2 units of hats. [1 bicycle = 2 hats or 600/300=2] Answer to 3. (b): Answer to 3. (b): Rayland will import bicycles. Domestically, they have to give Rayland will import bicycles. Domestically, they have to give up 4 hats to get a bicycle but with trade they have to give up up 4 hats to get a bicycle but with trade they have to give up only 3 hats. only 3 hats. DCC: Rayland DCC: Artland 1 B = 4 H 1 B = 2 H ¼ B= 1 H ½ B= 1 H Terms of Trade Terms of Trade 1 B = 3 H 1 B = 3 H 1/3 B = 1 H 1/3 B = 1 H Answer to 3. (c) (i): Yes, 5 hats is better than 2 hats they are getting domestically. Answer to 3. (d): 300 bicycles would become 900 and 600 hats would become 1,800, so the Answer to 3. (d): 300 bicycles would become 900 and 600 hats would become 1,800, so the DCC would still be 1 bicycle = 2 hats, same as before. Rayland still has a C.A. in hats. DCC would still be 1 bicycle = 2 hats, same as before. Rayland still has a C.A. in hats. Answer to 3. (c) (ii): No, Rayland is going to export hats so opportunity cost is ¼ bicycle. So 1/5 of a bicycle would not benefit them. 1 pt for “1 B = 2 H” 2 pts for “Rayland will import bicycles” 1 pt for “Yes, 5 H is better than 2 H” 1 pt for “No” 1 pt for “No change, so Rayland still has a comparative advantage in hats”